T.C. Memo. 2013-245
UNITED STATES TAX COURT
TERRY L. ELLIS AND SHEILA K. ELLIS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12960-11. Filed October 29, 2013.
Troy Renkenmeyer, for petitioners.
Elizabeth Abigail Raines, for respondent.
MEMORANDUM OPINION
PARIS, Judge: On March 28, 2011, respondent issued a notice of
deficiency for tax years 2005 and 2006 to petitioners Terry L. Ellis and Sheila K.
Ellis, taking alternative positions for these two tax years. The notice determined a
deficiency in petitioners’ Federal income tax for tax year 2005 of $135,936 and an
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[*2] accuracy-related penalty under section 6662(a)1 of $27,187. In the
alternative, the notice determined a deficiency in petitioners’ Federal income tax
for tax year 2006 of $133,067, an addition to tax under section 6651(a)(1) of
$19,731, and an accuracy-related penalty under section 6662(a) of $26,613.
Petitioners seek redetermination of the above-stated deficiencies, penalties,
and additions to tax. The issues for decision are:
(1) whether petitioner Terry L. Ellis participated in one or more prohibited
transactions under section 4975 with his individual retirement account (IRA) in
2005 when he directed his IRA to invest in CST Investments, LLC (CST),
pursuant to an arrangement or understanding whereby he was designated the
general manager and would subsequently receive compensation and other benefits
from that company;
(2) whether Mr. Ellis participated in one or more prohibited transactions
under section 4975 when he caused CST to pay him compensation of $9,754 in tax
year 2005;
1
All section references are to the Internal Revenue Code in effect for the tax
years at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
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[*3] (3) whether Mr. Ellis participated in one or more prohibited transactions
under section 4975 when he caused CST to pay him compensation of $29,263 in
tax year 2006;
(4) whether Mr. Ellis participated in one or more prohibited transactions
under section 4975 when he caused CST to pay rent to CDJ, LLC, an entity owned
by petitioners and their children, in tax year 2006;
(5) whether petitioners received unreported retirement income as a result of
Mr. Ellis’ participation in a prohibited transaction under section 4975 with his
IRA in 2005, or, in the alternative, 2006;
(6) whether petitioners are liable for the 10% additional tax under section
72(t) for tax year 2005, or, in the alternative, 2006;
(7) whether petitioners are liable for the accuracy-related penalty under
section 6662(a) for tax year 2005, or, in the alternative, 2006; and
(8) whether petitioners are liable for an addition to tax under section
6651(a)(1) for tax year 2006.
Background
The parties submitted this case for decision fully stipulated under Rule
122(a). The stipulation of facts filed on June 12, 2012, is incorporated herein by
this reference. Petitioners resided in Missouri at the time their petition was filed.
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[*4] I. Tax Year 2005
A. Formation of CST
By 2005 petitioner Terry L. Ellis had accumulated a sizable amount in his
section 401(k) retirement plan account from his many years of service as an
employee at Aventis Pharmaceuticals, Inc. On or about April 19, 2005, Mr. Ellis
engaged the former law firm of petitioners’ current counsel of record in this case
to advise him regarding the restructuring of his investment holdings. On May 25,
2005, the firm helped petitioners to organize CST, a Missouri limited liability
company.2 The operating agreement of CST, also dated May 25, 2005, was signed
by Mr. Ellis on behalf of First Trust Co. of Onaga FBO Terry Ellis IRA, an entity
that did not yet exist. The agreement listed the original members of CST to be
First Trust Co. of Onaga FBO Terry Ellis IRA, owning 980,000 membership units
or 98% in exchange for an initial capital contribution of $319,500, and a member
not a party to this action owning the remaining 20,000 membership units or 2%.
Mr. Ellis also requested a Federal taxpayer identification number for CST on a
Form SS-4, Application for Employer Identification Number, which was dated
2
Despite its name, CST Investments, LLC is not a registered investment
company under the Investment Company Act of 1940.
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[*5] May 16, 2005. On June 2, 2005, a Federal tax identification number was
assigned to CST.
CST was formed to engage in the business of used vehicle sales. It
conducted its operations in Harrisonville, Missouri. At all relevant times during
tax years 2005 and 2006, Mr. Ellis was the general manager of CST and, in
addition, worked at the company in its used car business.3
On or about June 7, 2005, Mr. Ellis submitted an application to establish an
IRA with First Trust Co. of Onaga (First Trust). On or about June 14, 2005, Mr.
Ellis, as general manager of CST, filed a Form 8832, Entity Classification
Election, on behalf of CST, in which it elected to be treated as an association
taxable as a corporation.4
On or about June 22, 2005, Mr. Ellis received a distribution of $254,206.44
from the section 401(k) account he had accumulated with his former employer,
3
Mr. Ellis was the designated general manager in the operating agreement
for CST. Article II of the operating agreement further stated: “The General
Manager shall have full authority to act on behalf of the Limited Liability
Company”. See also Mo. Rev. Stat. secs. 347.065, 347.069 (2012).
4
Mo. Rev. Stat. sec. 347.187.2 (2012) provides that a Missouri limited
liability company and its members shall be classified and treated on a basis
consistent with the limited liability company’s classification for Federal income
tax purposes.
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[*6] Aventis Pharmaceuticals.5 Mr. Ellis took the distribution check from his
section 401(k) account and deposited the entire $254,206.44 into his newly
opened IRA.6 On or about June 23, 2005, Mr. Ellis caused his IRA to acquire
779,141 membership units of CST in exchange for a cash payment of $254,000
from the IRA to CST.7
On or about August 19, 2005, Mr. Ellis received a second distribution of
$67,138.81 from the section 401(k) account he had accumulated at Aventis
Pharmaceuticals.8 9 As with the first distribution check, Mr. Ellis deposited the
entire $67,138.81 into his IRA. On or about August 23, 2005, Mr. Ellis caused his
IRA to acquire 200,859 membership units of CST, in exchange for a payment of
5
The distributor, T. Rowe Price, issued to petitioners a Form 1099-R,
Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans,
IRA’s, Insurance Contracts, etc., for tax year 2005 to report the $254,206.44
distribution.
6
This transaction was reported as a rollover contribution by T. Rowe Price.
7
After this payment to CST and applicable fees, $191 in cash remained in
the IRA account.
8
The distributor, T. Rowe Price, issued to petitioners a second Form 1099-R
for 2005 to report the $67,138.81 distribution.
9
The record also reflects that, at some point during tax year 2005, Mr. Ellis
received a third distribution of $21 from the sec. 401(k) account he had
accumulated with Aventis Pharmaceuticals. This distribution was also reported by
T. Rowe Price on a Form 1099-R for tax year 2005.
-7-
[*7] $65,500 from the IRA to CST.10 Following the completion of the $319,500
capital contribution, a single membership certificate for 980,000 units was issued
to First Trust FBO Terry Ellis IRA on June 23, 2005.
On or about November 28, 2005, First Trust, the custodian of Mr. Ellis’
IRA, requested a current estimate of the fair market value of the IRA’s
membership interest in CST. On December 20, 2005, Mr. Ellis provided a current
valuation of CST to the IRA custodian. Subsequently, on or about June 20, 2006,
First Trust issued to Mr. Ellis and to respondent a Form 5498, IRA Contribution
Information, for tax year 2005 reflecting a fair market value of the IRA account of
$321,253. This amount consisted of $319,480 of value in the 98% interest in CST
and the remaining cash balance of $1,773.11
During tax year 2005 CST paid Mr. Ellis $9,754 as compensation for his
role as general manager of CST. CST made these payments through checks issued
from its corporate checking account, and not from the custodial account of Mr.
Ellis’ IRA. On or before March 15, 2006, CST filed a Form 1120, U.S.
Corporation Income Tax Return, for tax year 2005. CST claimed a deduction from
10
After this payment to CST and applicable fees, $1,794 in cash remained in
the IRA account.
11
The cash balance was reduced by approximately $21 in custodial fees
between August 23 and December 20, 2005.
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[*8] corporate income for compensation paid to corporate officers, which
consisted only of the $9,754 paid to Mr. Ellis.12 In addition to what appears to be
normal operating expenses, CST also listed additional deductions of $12,106 for
payroll expenses, $5,462 for bank service charges, and $8,910 for legal fees.13
B. Formation of CDJ, LLC
On or about June 24, 2005, petitioners’ counsel’s former firm also
organized CDJ, LLC (CDJ), a Missouri limited liability company, on behalf of Mr.
Ellis. From that point to the date the parties executed the stipulation of facts, the
members of CDJ were Terry L. Ellis (50%), Sheila Ellis (12.5%), and their three
children: Christopher Ellis (12.5%), Douglas Ellis (12.5%), and Jamie Ellis
(12.5%). CDJ did not file a Form 8832 and did not otherwise elect to be classified
as an association taxable as a corporation.
12
This amount was reported on a Form W-2, Wage and Tax Statement,
issued to Mr. Ellis for tax year 2005 and subsequently reported by petitioners on
their 2005 Federal income tax return as wages. As discussed below, the original
operating agreement of CST authorized Mr. Ellis to be paid guaranteed payments
by the company in his role as general manager. It is unclear whether this amount
paid as “officer compensation” was issued under the guaranteed payment
provision of the operating agreement or was issued as wages to Mr. Ellis.
13
The original engagement letter with petitioners’ counsel’s firm listed a
legal fee of “3% of the amount accessed from deferred compensation accounts
* * * payable upon the investment by your IRA into the corporation.”
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[*9] The purpose of CDJ was to acquire investment property and to rent such
property through the issuance of commercial leases. On December 28, 2005, CDJ
acquired title to a parcel of real property at 23621 S. State Route 291,
Harrisonville, Missouri (Harrisonville parcel). The purchase price for the
Harrisonville parcel was $142,000. CDJ paid $12,000 down and obtained a
mortgage for the balance of $130,000 from the Bank of Lee’s Summit.
On or before April 15, 2006, a Form 1065, U.S. Return of Partnership
Income, was filed on behalf of CDJ for tax year 2005. This return reported neither
gross income nor receipts but did report expense deductions of $3,598, resulting in
a reported net loss of $3,598.
C. Petitioners’ 2005 Return
On or about May 6, 2006, petitioners filed their joint Federal income tax
return for tax year 2005. Petitioners reported total income of $75,270, consisting
of wages of $76,046,14 taxable refunds of State and local income taxes of $1,473,
and a loss on Schedule E, Supplemental Income and Loss, from CDJ of $2,249.15
14
Petitioners reported that Mr. Ellis had wage income from Aventis
Pharmaceuticals of $25,713 and CST of $9,754, while Mrs. Ellis had wage income
from an unrelated employer in the amount of $40,579.
15
This loss consisted of the $1,799 allocable to Mr. Ellis and the $450
allocable to Mrs. Ellis out of CDJ’s net loss of $3,598 for tax year 2005.
(continued...)
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[*10] On the return, petitioners also reported pension distributions of $321,266 but
did not report any portion of these distributions as taxable. Accordingly,
petitioners reported their gross income as $77,519 for tax year 2005. Petitioners
did not report that Mr. Ellis’ IRA purchased a total of 980,000 membership units
of CST in tax year 2005. Petitioners likewise did not disclose that CST, an entity
that had paid compensation to Mr. Ellis in 2005, was thus owned primarily by his
IRA.
II. Tax Year 2006
A. CST and CDJ Operations
On January 1, 2006, CST entered into an agreement to lease the
Harrisonville parcel from CDJ from January 1, 2006, to January 1, 2016. CST
used this real estate to operate its used car business. Throughout tax year 2006
CST made monthly rent payments to CDJ for use of the Harrisonville parcel as it
operated its used car business. These rent payments totaled $21,800 for tax year
2006.
Also during tax year 2006 CST paid $29,263 of compensation to Mr. Ellis
for his role as general manager of CST in operation of its used car business. Both
15
(...continued)
Petitioners’ Schedule A, Itemized Deductions, did not reflect any legal fees as an
expense paid for the production of income.
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[*11] the rent payments to CDJ and the compensation payments to Mr. Ellis were
made from CST’s corporate checking account and not from the custodial account
of Mr. Ellis’ IRA.
On or before July 6, 2007, CST filed its corporate income tax return for tax
year 2006. On this return CST claimed a deduction from corporate income for
compensation paid to corporate officers, consisting only of the $29,263 paid to
Mr. Ellis. On or before the same date, a partnership information return was filed
on behalf of CDJ for tax year 2006. The first page of this return reported zero
income and claimed zero deductions. However, the form later reported net rental
income from real estate of $830, subject to the following allocation to the
members of CDJ: $414 to Terry Ellis, $104 to Sheila Ellis, and $104 each to
petitioners’ three children, Christopher, Douglas, and Jamie.
B. Petitioners’ 2006 Return
On or about July 6, 2007, petitioners filed their joint Federal income tax
return for tax year 2006. Petitioners did not, before April 15, 2007, file a request
for extension of time to file. Petitioners reported their total income to be $72,705
for tax year 2006. Petitioners reported that Mr. Ellis had wage income from CST
of $29,263, while Mrs. Ellis had wage income from an unrelated employer of
$41,967. Petitioners also reported that they had taxable refunds of State and local
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[*12] income taxes of $863, pension income to Mr. Ellis from T. Rowe Price of
$93,16 and Schedule E income from CDJ of $519.17
Petitioners did not report any pension income other than the $93 from T.
Rowe Price. Petitioners again did not disclose that CST, an entity that had paid
compensation to Mr. Ellis in 2005, was owned primarily by his IRA.
III. The Notice of Deficiency
On March 28, 2011, respondent issued to petitioners a notice of deficiency
for tax years 2005 and 2006. This notice reflected respondent’s determination of a
deficiency in income tax of $135,936 for tax year 2005, or, in the alternative, a
deficiency in income tax of $133,067 for tax year 2006. The notice further
reflected respondent’s determination to impose on petitioners an accuracy-related
penalty under section 6662(a) of $27,187 for tax year 2005, or, in the alternative,
$26,613 for tax year 2006. The notice also reflected respondent’s determination of
16
Petitioners also reported their liability for an early distribution tax under
sec. 72(t) of $9 (10% of $93).
17
This income consisted of the $415 allocable to Mr. Ellis and the $104
allocable to Mrs. Ellis out of CDJ’s net income of $830 for tax year 2005.
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[*13] an addition to tax for failure to timely file a return under section 6651(a)(1)
of $19,731 for tax year 2006.18
Respondent’s determinations in the notice of deficiency were based on the
premise that at one of a few alternative points during tax years 2005 and 2006, Mr.
Ellis engaged in a prohibited transaction under section 4975 with his IRA.
Respondent further determined that as of the first day of the taxable year in which
the prohibited transaction occurred, Mr. Ellis’ IRA ceased to be an “eligible
retirement plan” under section 402 and the fair market value of the IRA was
deemed distributed to him on the first day of that taxable year under section 408.
Respondent determined that a prohibited transaction under section 4975
occurred at one of the following points: (1) when Mr. Ellis caused his IRA to
engage in the sale and exchange of membership interests in CST in tax year 2005;
(2) when Mr. Ellis caused CST, an entity owned by his IRA, to pay him
compensation in tax year 2005; (3) when Mr. Ellis caused CST, an entity owned
by his IRA, to pay him compensation in tax year 2006; or (4) when Mr. Ellis
18
Petitioners’ return as originally filed reflected an overpayment of $1,527
for tax year 2006. Respondent has asserted that petitioners will be liable for the
addition to tax under sec. 6651(a)(1) only to the extent the Court determines a
deficiency for tax year 2006.
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[*14] caused CST, an entity owned by his IRA, to enter into a lease agreement
with CDJ, an entity owned by both petitioners and their children in tax year 2006.
The notice of deficiency also reflected respondent’s determination that, for
the year in which the prohibited transaction occurred petitioners are liable for the
additional tax under section 72(t) for early distributions from a qualified
retirement plan.
On June 1, 2011, petitioners filed a petition in this Court for review of
respondent’s determinations with respect to tax years 2005 and 2006.
Discussion
I. Section 4975
A. Introduction
Section 4975 sets forth certain prohibited transactions with respect to a
qualified retirement plan, including an IRA described in section 408(a). Section
4975(c) defines these prohibited transactions as any direct or indirect: (1) sale or
exchange, or leasing, of any property between a plan and a disqualified person; (2)
lending of money or other extension of credit between a plan and a disqualified
person; (3) furnishing of goods, services, or facilities between a plan and a
disqualified person; (4) transfer to, or use by or for the benefit of, a disqualified
person of the income or assets of a plan; (5) act by a disqualified person who is a
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[*15] fiduciary whereby he deals with the income or assets of a plan in his own
interests or for his own account; or (6) receipt of any consideration for his own
personal account by any disqualified person who is a fiduciary from any party
dealing with the plan in connection with a transaction involving the income or
assets of the plan. These enumerated prohibited transactions are not mutually
exclusive; one transaction may fall within the parameters of more than one of the
identified transactions under section 4975. Janpol v. Commissioner, 101 T.C. 518,
525 (1993).
The purpose of section 4975, in part, is to prevent taxpayers involved in a
qualified retirement plan from using the plan to engage in transactions for their
own account that could place plan assets and income at risk of loss before
retirement. See generally sec. 4975; S. Rept. No. 93-383 (1974),1974-3 C.B.
(Supp.) 80; H.R. Rept. No. 93-807 (1974), 1974-3 C.B. (Supp.) 236. The
enumerated transactions set forth in section 4975 are meant to exhibit per se
examples of this kind of self-dealing, and participation in such prohibited
transactions is just that -- prohibited. See Leib v. Commissioner, 88 T.C. 1474,
1481 (1987). The fact that a transaction would qualify as a prudent investment
when judged under the highest fiduciary standards is of no consequence. Id.
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[*16] B. Fiduciary and Disqualified Person Status
For the purposes of section 4975, a fiduciary is defined as any person who:
(1) exercises any discretionary authority or discretionary control respecting
management of such plan or exercises any authority or control respecting
management or disposition of its assets; (2) renders investment advice for a fee or
other compensation, direct or indirect, with respect to any moneys or other
property of such plan, or has any authority or responsibility to do so; or (3) has
any discretionary authority or discretionary responsibility in the administration of
such plan. Sec. 4975(e)(3). Further, a fiduciary with respect to a qualified
retirement plan is also a disqualified person for the purposes of section 4975. Sec.
4975(e)(2)(A).
Mr. Ellis certainly exercised discretionary authority over his IRA and
likewise exercised control over the disposition of its assets. Mr. Ellis seeded his
plan in June of 2005 with the proceeds from his section 401(k) plan account with
his former employer. Mr. Ellis then exerted control over his IRA in causing it to
engage in the purchase of membership units of CST. Accordingly, Mr. Ellis was
a fiduciary of his IRA within the meaning of section 4975 and consequently a
disqualified person with respect to that plan.
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[*17] C. Formation of CST
As previously stated, section 4975 prohibits any direct or indirect sale or
exchange of any property between a plan and a disqualified person. Sec.
4975(c)(1)(A). In addition to a fiduciary as defined above, the term “disqualified
person” under section 4975(e)(2) also includes a corporation or a partnership of
which 50% or more of (1) the combined voting power of all classes of stock
entitled to vote or the total value of shares of all classes of stock of a corporation,
or (2) the capital interest or profits interest of a partnership, is owned directly or
indirectly or held by a fiduciary as described in section 4975(e)(2)(A). Sec.
4975(e)(2)(G). Section 4975(e)(4) incorporates the constructive ownership rule of
section 267(c)(1), which provides that “[s]tock owned, directly or indirectly, by or
for a corporation, partnership, estate, or trust shall be considered as being owned
proportionately by or for its shareholders, partners, or beneficiaries”.
Petitioners argue that Mr. Ellis did not engage in a prohibited transaction by
causing his IRA to invest in CST. Petitioners rely on Swanson v. Commissioner,
106 T.C. 76, 88 (1996), to show that CST was not a disqualified person at the time
the investment was made. In Swanson, the taxpayer organized a domestic
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[*18] international sales corporation19 known as Swanson’s Worldwide, Inc.
(Worldwide). The taxpayer then established an IRA at Florida National Bank and
subsequently executed a subscription agreement for the exchange of IRA funds for
2,500 shares of Worldwide original issue stock. The Court stated that a
“corporation without shares or shareholders does not fit within the definition of a
disqualified person under section 4975(e)(2)(G).” Id. The Court concluded that it
was only after Worldwide issued its stock to the taxpayer’s IRA that Worldwide
had become a disqualified person under section 4975(e)(2)(G).
The Court finds in this context that an LLC that elects to be treated as a
corporation and does not yet have members or membership interests is sufficiently
analogous to a “corporation without shares or shareholders”. Mr. Ellis organized
CST without taking any ownership interest in the company.20 In the original
operating agreement, dated May 25, 2005, Mr. Ellis’ IRA is shown as an investing
member with a 98% ownership interest in CST in exchange for an initial capital
contribution of $319,500. Mr. Ellis’ IRA was subsequently created on June 7,
19
Domestic international sales corporation is commonly referred to as
“DISC”.
20
Under Mo. Rev. Stat. sec. 347.037 (2012), “[a]ny person, whether or not a
member or manager, may form a limited liability company by signing and filing
articles of incorporation for such limited liability company with the secretary.”
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[*19] 2005, and the initial capital contribution was effected through the transfer of
funds to CST in payments of $254,000 and $65,500 on June 23 and August 23,
2005, respectively. The end result of this transaction was the creation of a new
entity, CST, with Mr. Ellis’ IRA as a founding member with a 98% ownership
interest. CST had no outstanding owners or ownership interests before the initial
capital contribution and therefore could not be a disqualified person at the time of
the investment by Mr. Ellis’ IRA. Accordingly, petitioners did not engage in a
prohibited transaction when they caused Mr. Ellis’ IRA to invest in CST.21
D. Compensation paid by CST to Mr. Ellis
The direct or indirect transfer to, or use by or for the benefit of, a
disqualified person of the income or assets of a plan is a prohibited transaction
under section 4975(c)(1)(D). Similarly, an act by a disqualified person who is a
fiduciary whereby he directly or indirectly deals with the income or assets of a
plan in his own interest or for his own account is a prohibited transaction under
section 4975(c)(1)(E).
21
Respondent has also argued that Mr. Ellis engaged in a prohibited
transaction when he caused his IRA to invest in CST because the investment was
made as part of an arrangement whereby it was expected that a prohibited
transaction would later occur under sec. 4975(c)(1)(D) or (E). In light of the
following analysis, the Court finds it unnecessary to address these arguments at
this time.
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[*20] As detailed above, Mr. Ellis was a fiduciary of his IRA and therefore a
disqualified person. In addition, Mr. Ellis was the sole individual for whose
benefit the IRA was established and therefore the beneficial owner of 98% of the
outstanding membership interests of CST. See secs. 4975(e)(4), 267(c)(1).
Because Mr. Ellis, a fiduciary of his IRA, was the beneficial shareholder of more
than 50% of the outstanding ownership interest in CST, CST met the definition of
a disqualified person under section 4975(e)(2)(G). See Swanson v.
Commissioner, 106 T.C. at 88 n.15.
During tax year 2005 CST paid $9,754 to Mr. Ellis. On CST’s corporate
income tax return for tax year 2005, this amount is reflected as officer
compensation. Section 2.3 of the operating agreement for CST states that “the
General Manager shall be entitled to such Guaranteed Payment as is approved by
the members.” It is unclear whether Mr. Ellis was issued compensation under this
guaranteed payment provision or as wages. However, as the fiduciary of his IRA--
a member of CST with 98% of the outstanding ownership interest--and the general
manager of CST, Mr. Ellis ultimately had discretionary authority to determine the
amount of his compensation and effect its issuance in either circumstance.
Petitioners argue that Mr. Ellis did not engage in a prohibited transaction
when he caused CST to pay him compensation because the amounts it paid to him
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[*21] did not consist of plan income or assets of his IRA but merely the income or
assets of a company in which his IRA had invested. However, CST was funded
almost exclusively by the assets of Mr. Ellis’ IRA. Furthermore, the assets of Mr.
Ellis’ IRA consisted only of its ownership interest in CST, valued at $319,480,
and $1,773 in cash. To say that CST was merely a company in which Mr. Ellis’
IRA invested is a complete mischaracterization when in reality CST and Mr. Ellis’
IRA were substantially the same entity. In causing CST to pay him compensation,
Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in
violation of section 4975(c)(1)(D). Furthermore, in authorizing and effecting this
transfer, Mr. Ellis dealt with the income or assets of his IRA for his own interest or
for his own account in violation of section 4975(c)(1)(E).
Petitioners also argue that section 4975(d)(10) exempts the payment of
compensation by CST to Mr. Ellis in tax year 2005 from being classified as a
prohibited transaction. That section provides that the prohibited transactions set
forth under section 4975(c) shall not apply to receipt by a disqualified person of
any reasonable compensation for services rendered, or for the reimbursement of
expenses properly and actually incurred, in the performance of his duties with the
plan. However, the amounts CST paid as compensation to Mr. Ellis were not for
services provided in the administration of a qualified retirement plan in managing
- 22 -
[*22] its investments, but rather for his role as general manager of CST in
connection with its used car business. Accordingly, section 4975(d)(10) does not
apply. See Lowen v. Tower Asset Mgmt., Inc., 829 F.2d 1209, 1216 (2d Cir.
1987) (finding that section 408(c)(2) of the Employee Retirement Income Security
Act of 1974 (ERISA), the parallel provision to section 4975(d)(10), exempts the
fees and compensation paid pursuant to a plan’s investment management
agreement, but not other compensation from companies in which the plan is
invested).22
In essence, Mr. Ellis formulated a plan in which he would use his retirement
savings as startup capital for a used car business. Mr. Ellis would operate this
business and use it as his primary source of income by paying himself
compensation for his role in its day-to-day operation. Mr. Ellis effected this plan
by establishing the used car business as an investment of his IRA, attempting to
preserve the integrity of the IRA as a qualified retirement plan. However, this is
precisely the kind of self-dealing that section 4975 was enacted to prevent. For
22
The Court has previously found that to the maximum extent possible the
prohibited transaction rules are identical in the labor and tax provisions, so they
will apply in the same manner to the same transaction. Thus, the caselaw
interpreting ERISA is instructive with regard to interpreting the prohibitive
transactions under sec. 4975. See Leib v. Commissioner, 88 T.C. 1474, 1480-
1481 (1987).
- 23 -
[*23] the foregoing reasons, the Court sustains respondent’s determination that
Mr. Ellis engaged in prohibited transactions under section 4975(c)(1)(D) and (E)
when he caused CST to pay him compensation of $9,754 in tax year 2005.23 24
II. Effect of the Prohibited Transaction
A. Inclusion in Gross Income
If, during any taxable year of an individual for whose benefit any IRA is
established, that individual or his beneficiary engages in a prohibited transaction
under section 4975, the account will cease to be an IRA as of the first day of the
taxable year. Sec. 408(e)(2)(A). In such a case, the IRA in question will no
longer be exempt from tax under section 408(e)(1). Further, where such an
account ceases to be an IRA by reason of section 408(e)(2)(A), the account is
deemed to have been distributed on the first day of the taxable year in an amount
equal to the fair market value of all the assets of the account on that first day. Sec.
408(e)(2)(B); sec. 1.408-4(d)(1), Income Tax Regs.
23
Since the Court has determined that a prohibited transaction occurred in
tax year 2005, it is unnecessary to consider whether any later transactions engaged
in by petitioners were prohibited under sec. 4975.
24
Unlike this case, the Court in Peek v. Commissioner, 140 T.C. __, __ (slip
op. at 3 n.2) (May 9, 2013), concluded it did not need to reach the additional
question of whether prohibited transactions occurred under secs. 4975(c)(1)(D)
and (E) when the company made payments of wages to the taxpayers.
- 24 -
[*24] Section 61(a) defines gross income as all income from whatever source
derived, including (but not limited to) annuities and pensions. See sec. 61(a)(9),
(11). Section 408(d)(1) provides: “Except as otherwise provided in this
subsection, any amount paid or distributed out of an individual retirement plan
shall be included in gross income by the payee or distributee, as the case may be,
in the manner provided under section 72.” See Arnold v. Commissioner, 111 T.C.
250, 253 (1998); sec. 1.408-4(a), Income Tax Regs.
As detailed above, petitioners engaged in a prohibited transaction under
section 4975 in tax year 2005. Accordingly, the entire amount of $321,366.25
converted from Mr. Ellis’ section 401(k) plan account is deemed distributed on
January 1, 2005, under section 408(e)(2)(A). That amount is therefore includible
in petitioners’ gross income for tax year 2005 under sections 408(d)(1) and 72(a).
Because respondent determined alternative deficiencies for tax years 2005 and
2006, petitioners are therefore not liable for respondent’s determinations with
respect to tax year 2006.25
25
This includes the entire deficiency as well as the associated addition to tax
under sec. 6651(a)(1) and the accuracy-related penalty under sec. 6662(a).
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[*25] B. Section 72(t)
Section 72(t) provides for a 10% additional tax on early distributions from
qualified retirement plans unless the distribution falls within a statutory
exemption. The most common of these exemptions include distributions that are
made on or after the date on which the taxpayer attains age 59½ and distributions
that are attributable to the taxpayer’s being disabled. Sec. 72(t).
The parties have stipulated that Mr. Ellis had not attained the age of 59½ by
January 1, 2005. Petitioners allege no other exemption under which they would
escape the additional tax imposed by section 72(t). Accordingly, petitioners are
liable for the 10% additional tax on the $321,366.25 deemed distribution for tax
year 2005.
III. Section 6662(a) Penalty
Section 6662(a) and (b)(1) and (2) imposes an accuracy-related penalty
equal to 20% of an underpayment attributable to any substantial understatement of
income tax or to negligence or disregard of rules or regulations. Under section
7491(c), the Commissioner has the burden of production to show that the
imposition of a penalty under section 6662(a) is appropriate.
Section 6662(d) defines a “substantial understatement of income tax” as an
understatement that exceeds the greater of: (1) 10% of the amount of tax required
- 26 -
[*26] to be shown on the return, or (2) $5,000. “Negligence” includes any failure
to make a reasonable attempt to comply with the provisions of the Code, and
“disregard” includes any careless, reckless, or intentional disregard of rules or
regulations. Sec. 6662(c).
On their 2005 tax return petitioners reported total income tax due of $4,986.
Respondent has demonstrated that the amount of tax required to be shown on
petitioners’ 2005 return was $140,922.26 Petitioners’ understatement of $135,936
is therefore greater than 10% of the tax required to be shown on the return, which
is greater than $5,000. Accordingly, respondent has met his burden of production
under section 7491(c).
No penalty will be imposed under section 6662(a) if the taxpayer establishes
that he acted with reasonable cause and in good faith. Sec. 6664(c)(1).
Circumstances that indicate reasonable cause and good faith include reliance on
the advice of a tax professional or an honest misunderstanding of the law that is
reasonable in light of all the facts and circumstances. Sec. 1.6664-4(b), Income
Tax Regs. The taxpayer has the burden of proving that he acted with reasonable
cause and in good faith. Rule 142(a); Higbee v. Commissioner, 116 T.C. 438,
446-447 (2001). Regulations promulgated under section 6664(c) further provide
26
This amount includes the additional tax of $32,137 under sec. 72(t).
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[*27] that the determination of reasonable cause and good faith “is made on a
case-by-case basis, taking into account all pertinent facts and circumstances.” Sec.
1.6664-4(b)(1), Income Tax Regs.
The parties have agreed in the stipulation of settled issues filed on June 12,
2012, that petitioners have not provided sufficient evidence and have not
otherwise proven reasonable cause for relief from the penalty determined under
section 6662(a). Accordingly, petitioners are liable for the section 6662(a)
accuracy-related penalty for tax year 2005.
All other adjustments for tax year 2005 reflected on petitioners’ notice of
deficiency are computational. The Court has considered all of the arguments made
by the parties and, to the extent they are not addressed herein, they are considered
unnecessary, moot, irrelevant, or without merit.
To reflect the foregoing,
An appropriate decision
will be entered.